The present invention relates to evaluating, substituting and optimizing investment asset portfolios based on performance history to facilitate the investment process. An investment asset portfolio may consist of any combination of long and short positions in domestic and foreign, common and preferred stocks; corporate and government bonds; convertible securities; real estate securities; commodities; options, futures and similar derivative contracts; and any other tradable investment instruments. In the preferred embodiment of the present invention, the aforementioned portfolio is one and the same with a portfolio of holdings of a single mutual fund. In another embodiment, the aforementioned portfolio comprises a plurality of positions in various mutual funds. In yet another embodiment, the aforementioned portfolio comprises any arbitrary combination of the above investment instruments selected by a professional portfolio manager or an individual investor. In all cases, for the purpose of this specification, the aforementioned portfolio is referred to as the analyzed portfolio. The analyzed portfolio is characterized by periodic returns, such as the daily, weekly, monthly, quarterly or yearly (annual) relative increases or decreases in portfolio value, which facilitate comparing the performance of the analyzed portfolio to that of alternative portfolios.
In contrast to the analyzed portfolio, the term reference portfolio denotes an investment asset portfolio that comprises exchange traded funds (ETFs), exchange traded vehicles (ETVs), exchange traded notes or certificates (ETNs), Standard and Poor's Depositary Receipts (SPDRs), Holding Company Depositary Receipts (HOLDRs), and/or index mutual funds. For the purpose of this specification, these investment instruments are collectively referred to as exchange-traded products (ETPs). The ETPs were first introduced to the financial markets in the early 1990s, and have recently gained in popularity among individual and institutional investors. The main advantages of ETPs are their broad representation of the various market indices, diversification over many individual securities, low management expenses, tax-efficient structure, transparency, good liquidity, and, with the exception of index mutual funds, an intra-day trading capability. In addition, large brokerage and mutual fund firms have lately introduced a low-commission or no-commission trading of a significant number of ETPs, which facilitates periodic portfolio adjustments.
The fundamental factors that determine the performance of any investment portfolio are its periodic return and risk. The return of a portfolio is typically calculated as a linear percentage of increase or decrease of the portfolio value over an evaluation period, such as a day, week, month, quarter, or year (annual) period. In addition, given the log-normal distribution of portfolio returns over time, a natural logarithm of the ratio of the ending and starting portfolio values, expressed as a percentage, is also used to calculate correlations of returns among various portfolios in a period of time.
The value of the portfolio is determined not only by the sum of prices of the portfolio holdings, but also by the portfolio distributions. These distributions take multiple forms, such as qualified and unqualified dividends; short-term and long-term capital gains; forward and reverse share splits; capital returns; special cash dividends; and other disbursements. Distributions are determined by the underlying portfolio securities, the portfolio trading history, and the regulatory environment. Generally, distributions can take place any time during the portfolio evaluation period. To make the analysis consistent, these distributions must be reflected in corrections to the closing value of a portfolio or security at the end of each evaluation period. These corrections result in an adjusted close price as opposed to a regular close price, such as the one reported for an asset by a stock exchange at the close of a trading day. The adjustment is calculated according to formulae known in the art. In addition, the adjusted close price may take into account a discrepancy between the market value of the portfolio and the sum total of the values of its assets, which, for example, may be the case with certain ETPs trading at a discount. Portfolio returns calculated in the linear and logarithmic manner with the use of adjusted close prices instead of regular close prices are called total returns.
A standard deviation of portfolio returns in an evaluation period is used as a statistical measure of risk (volatility) of a portfolio. Portfolios of risky assets generally exhibit high standard deviation of returns. Desirable portfolios have higher returns at a given level of risk or, conversely, lower risk at a given level of returns, than alternative portfolios.
According to the modern portfolio theory (MPT) and the capital asset pricing model (CAPM), developed from the 1950s to 1970s, the performance of an analyzed portfolio can be measured by an alpha term that encompasses excess, risk-adjusted returns of the portfolio over the market returns, and by a beta factor that links the variability of analyzed returns to that of market returns. The desirable characteristics of high alpha and low beta of a portfolio can be attributed to a number of factors, such as a manager's skill in selection of the underlying securities, market timing, or just pure luck. In general, portfolio managers should be rated by their alpha and not beta performance, with the latter derived from correlation with market returns.
The problem arises with the definition of market returns. Frequently in financial practice, a single large-capitalization U.S. stock market index, such as the Dow Jones Industrial Average (DJIA, introduced in 1896) or Standard and Poor's 500 (S&P 500, introduced in 1957) is assumed to represent a market benchmark. Alternative approaches try to account for smaller capitalization and foreign stocks, as well as domestic and foreign, corporate and government bonds. However, in all these cases, once a single reference index is chosen, it remains largely static, unlike the analyzed portfolio whose composition (membership of individual securities and their corresponding weights in relation to the total value of the portfolio) may frequently and significantly change at the manager's discretion. In addition, the variability of returns of the reference is fixed in the sense that it arises from only the chosen index. Depending on the level of correlation between returns of the analyzed portfolio and reference index, the calculated excess return of the portfolio may lead to erroneous conclusions about its performance, i.e., portfolio returns not systematically explained by returns of the index are mistaken for alpha. Therefore, it is important to align the selection of the benchmark with the nature of the analyzed portfolio.
Another approach, typically used to rate and rank actively-managed mutual funds, is to evaluate analyzed portfolios on a relative basis. In that case, the performance of an analyzed portfolio is periodically compared to an average performance of its peer portfolios. The peers are determined on the basis of having similar holdings, which gives rise to common investment categories or styles, such as large-capitalization growth, mid-capitalization value, or small-capitalization blend stock funds, etc. This approach is erroneous in that it artificially lowers the performance threshold—if most of the peers in a given category underperform the market, which is frequently the case with actively-managed mutual funds, high relative ratings of some funds are misleading. It is also known in the art that newly-acquired high relative ratings result in abnormally large inflows of investments into these funds, which subsequently tend to underperform both their peers and the market, thus providing a disservice to investors. Therefore, it is essential to evaluate analyzed portfolios on an absolute instead of a relative basis, i.e., against a properly-chosen market reference instead of peers.
With actively-managed mutual funds, investors face additional problems of the style drift, market timing, window dressing, excessive trading, abnormally high fees, and index resemblance. Some mutual funds frequently change their investment styles and migrate between investment categories. This means that investors are being misinformed as to the true nature of their investments. Fund managers also tend to engage in market timing, placing large bets on the various macro-economic events they foresee taking place in the future. For example, managers may bet on the direction of interest rates, currency exchange rates, over- or under-performance of specific industries or sectors of the economy, etc. These bets frequently increase volatility of fund returns and generate losses to investors. Because the U.S. mutual funds have to report their holdings quarterly, some managers engage in a practice called window dressing, which entails replacing the under-performing or out-of-style positions with more attractive positions just before the end of the quarter. This deceptive practice misleads fund investors as to the true nature of fund holdings throughout the quarter. Fund managers often engage in short-term trading strategies, which results in excessive portfolio turnover, increased risk, and potential tax liabilities to investors. Frequent changes of a mutual fund portfolio composition due to market timing, window dressing, and short-term trading also result in excessive brokerage fees that decrease the fund's returns to its investors. Fund managers frequently charge investors steep front- and back-end transaction fees, as well as ongoing management, distribution, and other types of fees that further reduce returns. Finally, due to high correlations of returns of individual securities, especially in market downturns, active fund managers find it increasingly difficult to identify securities that generate market-beating returns.
What is needed is a system to critically and automatically evaluate portfolios (i.e., the analyzed portfolios) and output information based on the analysis to the user.
It would be desirable to provide a system that provides for automatic investments in the analyzed portfolios or synthesized reference portfolios that may in some cases be equivalent or superior to the analyzed portfolio.